Bitcoin explained: the digital currency making millionaires

The digital currency bitcoin has exploded in popularity since it began four years ago.

Where once a single bitcoin was worth a few cents online, it is now pushing on $1,000 per coin, creating millionaires in the process.

There have been many reported cases where people mined thousands of relatively worthless bitcoins as a hobby years ago, only to now realise they are rich.

One IT worker even threw out a hard drive containing 7,500 bitcoins, only to later find out his haul would have been worth $8.2 million.

If you want to know whether it is worth getting into and you cannot tell a bitcoin from a blockchain, read our explainer to see how the currency works.

What is bitcoin?

Bitcoin is a digital cryptocurrency that is decentralised and operates using a peer-to-peer network.

Unlike other currencies, it has no central authority or government-based backing.

It is a digital currency and is essentially a code that is traded between two people.

It was created by someone under the pseudonym of Satoshi Nakamoto and released as a working beta in 2009.

Satoshi's true identity remains a mystery as he disappeared from the scene in 2010 after seemingly handing over the reins to Gavin Andresen, the chief scientist at the Bitcoin Foundation.

During the early years some people collected thousands of bitcoins each, mostly at a worth of less than a dollar per coin.

Bitcoin was a niche curiosity, but after mainstream coverage and several market surges and crashes it was worth nearly $1,000 per bitcoin (in November 2013).

It can be traded for other currencies or real world goods and new bitcoins can be created by 'mining'.

There is a limit of just under 21 million bitcoins that can be created.

Once the limit is reached, no more bitcoins can be made.

However, a single bitcoin can be subdivided as far down as the eighth decimal place (0.00000001BTC) to buy smaller goods using just a fraction of the bitcoin.

The entire currency is underpinned by a public ledger called the blockchain, which records who owns what bitcoins and all transactions ever made in the currency.

Whenever a transaction is made it is added to the blockchain which is confirmed by other users using the peer-to-peer network.

Due to the nature of the blockchain, transactions cannot be reversed, only new transactions can be recorded to the chain.

Bitcoins are essentially codes added to the blockchain, which are secured using encrypted digital wallets.

A wallet operates by having a public address and a private key.

The public address is used by other people to send bitcoins to your wallet, whereas the private key is held by the owner and used to access and make payments from the wallet.

How do you create bitcoins?

When a user sends bitcoins to another user the transaction needs to be confirmed as valid and added to the public ledger of transactions and ownership - the blockchain - using a series of complex computations.

New bitcoins are rewarded to users who use their home computers or specialised hardware connected to the network to carry out these calculations.

This time-intensive pursuit is known as bitcoin mining.

The most recent transactions made on the network are bundled up into a transaction 'block', which is solved roughly every 10 minutes.

Once a user solves the mathematical problem to find a valid hash key it is added to the blockchain, verifying bitcoin transactions between users, while at the same time rewarding the miner with new bitcoins.

It can take a while for miners to reap rewards as only the first user to solve the block by finding one of a number of valid hash keys is rewarded with bitcoins.

During the early days of bitcoin in 2010-2011 a common household computer would have been powerful enough to mine for dozens of new coins using its CPU or GPU.

But that is not the case today.

The currency automatically regulates the difficulty of the mathematical problem (adding complexity to the hash value computers need to find) as well as the number of bitcoins received as a reward.

If a lot of people are connected to the network to mine for bitcoins the difficulty of solving a block increases - this is known as the hash rate.

Similarly, it decreases when less people are seeking new bitcoins.

The number of bitcoins rewarded also adjusts with an end result that means every four years only half the amount of coins created in the previous four years can be made.

This will continue until all 21 million bitcoins have been mined.

According to Bitcoin Charts, a total of 12 million bitcoins have been made as of November 2013.

Recently, the invention of specialised computers used solely for mining has dramatically increased the difficulty of obtaining a bitcoin.

These expensive machines mine for coins 24/7 and can perform the needed computations hundreds of times faster than a standard home computer.

Bitcoins can be mined solo or as part of a pool, but even then the bitcoin or fraction of the coin you receive will likely not be enough to cover the electricity cost.

Bitcoin mining was extremely easy when the network first began, but it is now out of the realm of common home computers.

How do you buy bitcoins?

Bitcoins can be bought from currency exchanges if you lack the computer hardware to mine for the currency or do not know anyone personally who will sell to you.

These exchanges let you buy and sell bitcoins for other real world currencies.

They make money by skimming a fee from the transactions.

Some shops have also begun selling physical 'bitcoins', which are minted but do not hold any particular value in the slug.

They come with a code for one bitcoin embedded in the physical coin that can be redeemed in a digital wallet.

Is it safe?

The bitcoin market has undergone a series of dramatic booms and busts.

It is anything but stable.

At the start of 2011 it was worth about 30 US cents and by the start of 2013 it was worth $US13.50.

In February it was trading for a high of $US32, then in March it hit $92, and in April $215, before dropping in the space of a week back down to $US65.

After a rocky few months it climbed from $US212 on November 1 to $US960 by November 27.

This should indicate that the currency is currently in a bubble.

The exchange price continues to fluctuate wildly day to day, sometimes by hundreds of dollars.

Early adopters who mined thousands of bitcoins rather quickly and cheaply stand to make hundreds of thousands of dollars, even millions, but for everyone else it will be a harder proposition to buy into.

Bitcoins have also been the focus of hacking attacks.

A common tactic is for a hacking group to run a denial of service attack against a popular bitcoin exchange, thus bringing down the website temporarily.

Bitcoin owners sell their coins at other exchanges in the panic, which brings down the price, and the hackers and opportunists jump in and buy them before the price stabilises and the attacked exchange comes back online.

Hackers and scammers have also successfully managed to rob bitcoin mining pools.

In early November a young Australian entrepreneur by the name of TradeFortress said more than 4,100 bitcoins then worth about $1.1 million had been stolen from his website.

The bitcoins were owned by users that had joined TradeFortress's mining pool.

While TradeFortress denies it was an inside job, there have been some cases of mining pools being set up to generate bitcoins with the help of other users only for the pool to disappear with all their shares of coins.

Thefts are made all the more worse as there is no way to reverse a bitcoin transaction and tracing a transaction is unlikely.

The US Congress has started holding a series of hearings to discuss the implications of virtual currencies like bitcoin.

While the US government says there is nothing illegal about virtual currencies, the anonymous nature of them make them popular for purchasing illegal goods.

This year the FBI shut down Silk Road - an online black market selling drugs and other illegal products that accepted bitcoins as a payment.

Other black markets on the dark web that sell things such as firearms and child abuse material also accept bitcoins.

But the digital currency is not just for the shady parts of the internet, it is gaining acceptance from mainstream websites and even real world businesses.

A US couple recently conducted an experiment to see if they could live solely on bitcoin instead of other currencies.

And in Canada the world's first bitcoin ATM has opened up.

Richard Branson has also begun accepting bitcoin payments for seats on upcoming flights into space on Virgin Galactic.

But despite growing in acceptance, the currency value is unstable and like with all financial matters people will need to do their own research before deciding whether to invest the time and money.

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